*799 Where subdividers transferred property to petitioner in aid of construction in consideration of petitioner's promise to furnish an adequate supply of water to consumers in the subdivisions, and petitioner later transferred the plant, including the property received from the subdividers, to a corporation for all its stock and bonds and its assumption of the agreement to supply water, held, the assumption of the agreement to supply water constituted a return of the cost to petitioner for the property so acquired, and petitioner's base on subsequent sale of the stock and bonds received in exchange for his assets was the cost of the assets exclusive of the value of the property received from the subdividers.
*1081 These proceedings are for the redetermination of deficiencies against H. T. Robinson for the years 1927 and 1928 in the respective amounts of $4,883.80 and $7,595.88, and against A. D. Robinson for the year 1928 in the sum of $7,595.88. At the hearing the respondent amended his answer to increase the deficiency against*800 petitioner H. T. Robinson for the year 1928 in an amount equal to the deficiency asserted against petitioner A. D. Robinson, the deficiency having been asserted against her on the erroneous assumption that she owned a one-half interest in certain stock, whereas petitioner H. T. Robinson was the sole owner of said stock.
The question presented for decision is whether the value of certain water mains, pipe lines, and other connections paid for by certain subdividers and transferred to petitioner H. T. Robinson may be included for the purpose of determining gain or loss on the subsequent sale of certain bonds and stock for which said assets were exchanged. The respondent admits in his brief that none of the profit derived from the sale of said bonds and stock is taxable to petitioner A. D. Robinson. The word "petitioner" as used hereinafter in our findings of fact, unless otherwise specified, refers to H. T. Robinson.
FINDINGS OF FACT.
Petitioner, H. T. Robinson, is a resident of Los Angeles, California. In 1921 he became the sole owner of a public utility business operated as a sole proprietorship under the assumed name of Ocean Park Heights Land & Water Co. Its business*801 was the furnishing of water to a certain territory located near the city of Venice, California. Its business was subject to the rules and regulations of the Railroad Commission of the State of California.
During the period January 1, 1922, to May 1, 1927, several real estate subdividers who had opened residential subdivisions in the neighborhood of Venice, California, came to the petitioner with the request that he furnish water to their various subdivisions. In order to do this it was necessary for the petitioner to have the territory covered by his franchise extended and to acquire extra wells in order to produce more water. Petitioner's franchise was extended to cover the territory embraced in these various subdivisions pursuant to an order of the Railroad Commission of California. *1082 Written contracts were entered into between the petitioner and the various subdividers under the terms of which the subdividers agreed to pay the cost of installing all the necessary water mains, pipes, canals, and other connections necessary for the furnishing of water and to transfer the title to such property upon completion to the petitioner, and the petitioner agreed to furnish*802 an adequate water supply to subdividers and to keep such property in repair. In some instances the contracts provided that the subdividers themselves should install the necessary connections, pay the cost thereof, and transfer title to the property to the petitioner; in other instances, the contracts provided for the petitioner to install the necessary connections and for reimbursement of the cost by the subdividers and transfer of title to petitioner.
The total net cost to the various subdividers of the water mains, pipes, and other connections installed by them between January 1, 1922, and May 1, 1927, was $170,439.93. Title to all of these water mains, pipes, and connections was duly transferred to the petitioner by the several subdividers. The fair market value of the property so transferred to the petitioner was at least $170,439.93.
The contracts entered into between the taxpayer and the various subdividers and the transfer by the latter to the petitioner of title to these properties were approved by the Railroad Commission of California and the cost of such improvements was reported to the Railroad Commission of California in the amount of $170,439.93.
The expense*803 of maintaining these improvements was borne by the taxpayer after title to them was transferred to him. The persons using water on the premises on which these various improvements were located received no concessions from the petitioner by way of reduced rates. They paid the same rates as other consumers in that area paid.
On May 1, 1927, petitioner organized the Ocean Park Heights Water Co., Inc., under the laws of California. He transferred to this corporation the entire assets of the Ocean Park Heights Land & Water Co., receiving in exchange therefor bonds of the corporation of the face value of $100,000 and 1,250 shares of the common capital stock. After this transfer the petitioner was the owner of all of the outstanding stock and bonds of the corporation. Included in the assets transferred to the corporation were the water mains, pipes, and connections, title to which had been transferred to petitioner by the various subdividers. The issuance by the corporation of all of its stocks and bonds to petitioner in exchange for the assets of the Ocean Park Heights Land & Water Co. was approved by the California Railroad Commission.
Later in 1927 the petitioner sold bonds*804 of the Ocean Park Heights Water Co., Inc., of the par value of $80,000 for $73,467.36. The *1083 petitioner and his wife, A. D. Robinson, filed a joint income tax return for the year 1927. No gain or loss was reported in that return from the sale of the bonds. The respondent determined that petitioner realized a profit of $37,715.43 from the sale of the bonds, being the excess of $73,467.36, the amount received for the bonds, over the sum of $35,751.93, the cost to the petitioner, as determined by the Commissioner, of the property transferred by the petitioner to the Ocean Park Heights Water Co., Inc. The basis of $35,751.93 did not include the value or cost of the water mains, pipe lines, and connections transferred to the petitioner by the various real estate subdividers and by the petitioner to the Ocean Park Heights Water Co., Inc., but represented only the cost to the petitioner of other property transferred by him to the Ocean Park Heights Water Co., Inc. The deficiency for the year 1927 is due in part to the respondent's action in including in the taxable income of petitioner and his wife, for the year 1927, a gain of $37,715.43 from the sale of said bonds, which*805 the Commissioner taxed at capital gain rates.
In computing the deficiency of petitioner for the year 1927 the respondent made an adjustment in the amount of $17,906.32, representing depreciation on petitioner's assets for the years 1923 to May 1, 1927, inclusive.
In 1928 the petitioner sold all of his stock in the Ocean Park Heights Water Co., Inc., for a net selling price of $120,470.04. The petitioner and his wife filed separate income tax returns for the year 1928. Each reported as ordinary gain from the sale of the stock the sum of $20,983.59. The respondent treated the entire sales price as gain and included one-half thereof, or $60,235.02, in the taxable income of each, the petitioner and his wife, and taxed same at capital gain rates.
OPINION.
ARNOLD: The petitioner contends that the amount of $170,439.93, representing the cost of the assets transferred to him by the subdividers in aid of construction, and thereafter transferred by him to the corporation together with other assets of the water company, for the bonds and stock of the corporation, was an expenditure properly chargeable to his capital account and should be included in his basis for determining loss*806 or gain on the sale of said bonds and stock under section 202(a) and (b). Petitioner further argues that these assets transferred to him in aid of construction constituted a gift to him and under section 204(a)(2) of the Revenue Act of 1926 may be included in his basis at their cost to the transferors.
The respondent contends that the transfer of these assets by the subdividers to petitioner was for a valuable consideration and not a gratuitous transfer or gift within the meaning of the above cited *1084 section of the statute and cites numerous cases to the effect that a gift must not have consideration. He further contends that petitioner acquired the water mains, pipe lines, and connections without cost to him, and, therefore, their cost should not be considered in determining gain or loss on the sale of the stock and bonds here in question.
Petitioner cites Edwards v. Cuba Railroad Co.,268 U.S. 628">268 U.S. 628, as controlling. That case does not answer the question we have to decide here. There, physical properties and money subsidies paid to the Cuba Railroad Co. by the Republic of Cuba were held not income to the donee within the meaning of the Sixteenth*807 Amendment. In the opinion the Court said:
* * * Such aids, gifts and grants from the government, subordinate political subdivisions or private sources - whether of land, other property, credit or money - in order to induce construction and operation of railroads for the service of the public are not given as mere gratuities. Burke v. Southern Pacific R.R. Co.,234 U.S. 669">234 U.S. 669, 679, 34 S. Ct. 907">34 S.Ct. 907, 58 L. Ed. 1527">58 L.Ed. 1527; Louisville & Nashville R.R. v.United States, decided March 2, 1925, 267 U.S. 395">267 U.S. 395, 45 S. Ct. 233">45 S.Ct. 233, 69 L. Ed. 678">69 L.Ed. 678. * * * The subsidy payments taxed were not made for services rendered or to be rendered. They were not profits or gains from the use or operation of the railroad, and do not constitute income within the meaning of the Sixteenth Amendment. See Stratton's Independence v. Howbert,231 U.S. 399">231 U.S. 399, 415, 34 S. Ct. 136">34 S.Ct. 136, 58 L. Ed. 285">58 L.Ed. 285; Eisner v. Macomber,252 U.S. 189">252 U.S. 189, 207, 40 S. Ct. 189">40 S.Ct. 189, 64 L. Ed. 521">64 L.Ed. 521, 9 A.L.R. 1570">9 A.L.R. 1570; Merchants' Loan & Trust Co. v. Smietanka, supra.
The donations in aid of construction were treated by the Supreme Court as constituting reimbursement for capital expenditures. *808 The Court pointed out that "Neither the laws nor the contracts indicate that the money subsidies were to be used for the payment of dividends, interest or anything else properly chargeable to or payable out of earnings or income." To the same effect is Liberty Light & Power Co.,4 B.T.A. 155">4 B.T.A. 155. See also El Paso Electric Co.,10 B.T.A. 79">10 B.T.A. 79; Tampa Electric Co.,12 B.T.A. 1002">12 B.T.A. 1002; Frank Holton & Co.,10 B.T.A. 1317">10 B.T.A. 1317.
The property in question was not given petitioner for services rendered or to be rendered to the subdividers. The service which petitioner was obligated to render was supplying water to the consumers in the subdivision, who paid the regular rates for water which obtained in that area. The property received represents the measure of cost of additional water mains and equipment which petitioner would have had to make in order to supply the subdivisions with water and is in the nature of reimbursement for construction costs. Edwards v. Cuba Railroad Co., supra.It became a part of petitioner's water system which was operated as a unit and from which income was derived.
The respondent's*809 argument that because a lessee is not entitled to claim depreciation on leased property, the petitioner is not entitled *1085 to a basis on the property transferred to him, is not convincing. The lessee is held not entitled to depreciation because he does not own the property, but the petitioner became the owner of the property transferred to him by the subdividers and it was a part of the capital used in his business. Ownership and not possession is the test in determining whether assets used in business are subject to depreciation, and where the owner of property used in business has paid a consideration for it he is entitled through depreciation to recover the value of the consideration paid.
The respondent argues that the transfer of the pipe lines, water mains, etc., was not a gift to petitioner, but was for a valuable consideration. At the same time he contends that they cost him nothing. We do not think these positions are consistent. We think it clear that the transaction here was not a gift in the sense that it was a gratuity. *810 Burke v. Southern Pacific Railroad Co.,234 U.S. 669">234 U.S. 669; Louisville & Nashville Railroad v. United States,267 U.S. 395">267 U.S. 395; Edwards v. Cuba Railroad Co., supra.The "donors" did not intend to make such a gift to petitioner. The relationship of the parties negatives any such intent. Both were interested in the benefits they hoped to reap by the arrangements. There was, as argued by the respondent, valuable consideration flowing to the subdividers from petitioner for the transfer of the property here in question. The parties were dealing at arm's length. The subdividers needed water to enable them to promote the subdivisions and they agreed to pay the cost of installing all the necessary mains, pipes, and connections, and to transfer title to such property to the petitioner. The petitioner agreed to maintain the property and to furnish an adequate water supply to the subdivisions. This promise constituted consideration for the property received. These contracts under which the gifts or grants in aid were made were, we think, valid and enforceable. The grantors having performed could require the petitioner to do so or respond*811 in damages.
There was, therefore, a mutual consideration between the parties and in the absence of any evidence to the contrary we assume that there was a quid pro quo, and that the obligation of petitioner was equal to the value of the property received. In other words, the consideration given by petitioner was reasonably worth what the subdividers paid for it. The parties themselves so considered it, or they would not have entered into the arrangements. That consideration was petitioner's enforceable promise to perform. The subdividers undoubtably hoped to recover the cost to them of the donations through the increased value of the property supplied with water.
The fair market value of the property transferred to petitioner in aid of construction was, when transferred to him, equal to its cost *1086 or $170,439.93. This was the value of the consideration given by the subdividers and we think must be regarded as representing the value of the consideration given by petitioner or the cost basis of the property transferred in the hands of petitioner. The cost to petitioner of the water plant or assets transferred, exclusive of the donations in aid of construction*812 was $35,751.93. This gives a total cost basis to petitioner of the assets transferred to the corporation for its stock and bonds of $206,191.86.
The statute is designed to tax the profit realized upon the sale or disposition of property and such profit is determined as the difference between the cost of the property and the amount so realized. A taxpayer is entitled to recover his cost as capital.
The consideration given by petitioner was his obligation under the contract to furnish an adequate supply of water to the subdivisions, which was executory and continuing. He is entitled to recover the value of this consideration. The expenditure made for any additional wells and for extending the water mains to the subdivisions has been capitalized and is included in the $35,751.93, allocated to the value of the assets transferred to the corporation, exclusive of the donations in aid of construction. The corporation took over the water plant as a going concern and the assets were transferred to it. It, therefore, assumed the executory obligation of petitioner under the contracts with the subdividers, and relieved petitioner of any further performance thereunder. Petitioner, *813 therefore, received in exchange for the assets of the water system not only the stock and bonds of the corporation, but was relieved at that time of performance under the contract with the subdividers. This assumption of performance constituted a full recovery of the consideration given by him for the donations in aid of construction. Thereafter the only part of his cost not recovered was the $35,751.93. This he is entitled to recover upon the sale of the stock and bonds which he received in the exchange. The difference between this amount and the amount received on disposition of the stock and bonds constitutes capital gain and is subject to tax. The transaction was similar to a sale where the purchaser assumes a mortgage and relieves the seller of liability, cf. Brons Hotels, Inc.,34 B.T.A. 376">34 B.T.A. 376; Hendler v. United States,17 Fed.Supp. 558. This reduced petitioner's cost basis to $35,751.93, which amount he is entitled to recover upon the sale of the stock and bonds received in exchange for the assets of the water company.
As to A. D. Robinson, we find there is no deficiency.
Decision will be entered under Rule 50.